Bodie2-IM-Ch12

CHAPTER12-PortfolioOpportunitiesandChoiceEnd-of-ChapterProblems1.Analyzetheexpert’sanswerstothefollowingquestions:a.Question:Ihaveapproximatelyone-thirdofmyinvestmentsinstocks,andtherestinamoneymarket.Whatdoyousuggestasasomewhat“safer”placetoinvestanotherone-third?Iliketokeepone-thirdaccessibleforemergencies.Expert’sanswer:Well,youcouldtry1or2yearTreasurybonds.You’dgetalittlebitmoreyieldwithnorisk.b.Question:Wherewouldyouinvestifyouweretostarttoday?Expert’sanswer:Thatdependsonyourageandshort-termgoals.Ifyouareveryyoung–sayunder40–anddon’tneedthemoneyyou’reinvestingforahomeorcollegetuitionorsuch,youwouldputitinastockfund.Evenifthemarkettanks,youhavetimetorecoup.And,sofar,nothinghasbeatenstocksoveraperiodof10yearsormore.Butifyouaregoingtoneedmoneyfairlysoon,forahomeorforyourretirement,youneedtoplayitsafer.Solution:a.Youarenotgettingalittlebitmoreyieldwithnorisk.Therealvalueofthebondpayoffissubjecttoinflationrisk.Inaddition,ifyoueverneedtoselltheTreasurybondsbeforeexpiration,youaresubjecttothefluctuationofsellingpricecausedbyinterestrisk.b.Theexpertisrightinpointingoutthatyourinvestmentdecisiondependsonyourageandshort-termgoals.Inaddition,theinvestmentdecisionalsodependsonothercharacteristicsoftheinvestor,suchasthespecialcharacterofthelaborincome(whetheritishighlycorrelatedwiththestockmarketornot),andrisktolerance.Also,thefactthatoveranyperiodof10yearsormorethestockbeatseverythingelsecannotbeusedtopredictthefuture.2.Supposethatyour58-year-oldfatherworksfortheRuffyStuffedToyCompanyandhascontributedregularlytohiscompany-matchedsavingsplanforthepast15years.Ruffycontributes$0.50forevery$1.00yourfatherputsintothesavingsplan,uptothefirst6%ofhissalary.Participantsinthesavingsplancanallocatetheircontributionsamongfourdifferentinvestmentchoices:afixed-incomebondfund,a“blend”optionthatinvestsinlargecompanies,smallcompanies,andthefixed-incomebondfund,agrowth-incomemutualfundwhoseinvestmentsdonotincludeothertoycompanies,andafundwhosesoleinvestmentisstockintheRuffyStuffedToyCompany.OverThanksgivingvacation,Dadrealizesthatyouhavebeenmajoringinfinanceanddecidestoreapsomeearlyreturnsonthattuitionmoneyhe’sbeeninvestinginyoureducation.Heshowsyouthemostrecentquarterlystatementforhissavingsplan,andyouseethat98%ofitscurrentvalueisinthefourthinvestmentoption,thatoftheRuffyCompanystock.a.AssumethatyourDadisatypicalrisk-aversepersonwhoisconsideringretirementinfiveyears.Whenyouaskhimwhyhehasmadetheallocationinthisway,herespondsthatthecompanystockhascontinuallyperformedquitewell,exceptforafewdeclinesthatwerecausedbyproblemsinadivisionthatthecompanyhaslongsincesoldoff.Inaddition,hesays,manyofhisfriendsatworkhavedonethesame.Whatadvicewouldyougiveyourdadaboutadjustmentstohisplanallocations?Why?b.IfyouconsiderthefactthatyourdadworksforRuffyinadditiontohis98%allocationtotheRuffystockfund,doesthismakehissituationmorerisky,lessrisky,ordoesitmakenodifference?Why?Solution:a.DadhasexposedhimselftoriskbyconcentratingalmostallofhisplanmoneyintheRuffyStockfund.Thisisanalogoustotaking100%ofthemoneyafamilyhasputasideforinvestmentandinvestingitinasinglestock.First,Dadneedstobeshownthatjustbecausethecompanystockhascontinuallyperformedquitewellisnoguaranteethatitwilldosoindefinitely.Thecompanymayhavesoldoffthedivisionswhichproducedpricedeclinesinthepast,butfutureproblemsareunpredictable,andsoisthemovementofthestockprice.“Pastperformanceisnoguaranteeoffutureresults”isthelesson.Chapter12-1Copyright©2009PearsonEducation,Inc.PublishingasPrenticeHall.FinancialEconomicsSolutionsManualSecond,Dadneedstohearaboutdiversification.Heneedstobecounseledthathecanreducehisriskbyallocatinghismoneyamongseveraloftheoptionsavailabletohim.Indeed,hecanreducehisriskconsiderablymerelybymovingallofhismoneyintothe“blend”fundbecauseitisdiversifiedbydesign:ithasafixed-incomecomponent,alargecompaniescomponent,andasmallcompaniescomponent.Diversificationisachievednotonlyviathethreedifferingobjectivesofthesecomponents,butalsoviathenumerousstocksthatcompriseeachofthethreecomponents.Finally,Dad’sageandhisretirementplansneedtobeconsidered.Peoplenearingretirementagetypicallybegintoshiftthevalueoftheirportfoliosintosaferinvestments.“Safer”normallyconnoteslessvariability,sothattheriskofalargedeclineinthevalueofaportfolioisreduced.Thisdeclinecouldcomeatanytime,anditwouldbeveryunfortunateifitweretohappenthedaybeforeDadretires.Inthisexample,thesafestoptionwouldbethefixed-incomebondfundbecauseofitsdiversifiedcompositionandinterest-bearingdesign,butthereisstillriskexposuretoinflationandthelevelofinterestrates.Notethatthetax-deferrednatureofthesavingsplanencouragesallocationtosomethingthatproducesinterestordividends.Asitstandsnow,Dadisveryexposedtoalargedeclineinthevalueofhissavingsplanbecauseitisdependentonthevalueofonestock.Individualequitiesovertimehaveproventoproducethemostvariableofreturns,soDadshoulddefinitelymovesome,probablyatleasthalf,ofhismoneyoutoftheRuffystockfund.Infact,agoodrecommendationgivenhisretirementhorizonoffiveyearswouldbetore-aligntheportfoliosothatithas50%inthefixed-income